Profile

Looking to the Past

Brad Friedlander is very interested in mortgage-backed bonds that predated the financial crisis. The willingness to re-evaluate the past has helped his Angel Oak Multi-Strategy Income fund beat its peers since its inception.

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You can't fault investors for being a bit giddy about the housing recovery: Looking to cash in on rising demand and prices, they've been snapping up everything from rental properties to home-builder stocks for many months.

But while those investors see a bright future for the sector, Brad Friedlander is more interested in its past. Friedlander's $1.8 billion
Angel Oak Multi-Strategy Income
fund (ticker: ANGLX) has a large weighting in "nonagency" mortgage loans (those not backed by the government) that predate the housing bubble. Those loans, stigmatized since the bubble burst, have been available for cheap—and they've powered Friedlander's two-year-old fund to an auspicious start.

"Five years removed from the height of the housing crisis, there are still opportunities within the fixed-income realm," says Friedlander, 36, managing partner at Angel Oak Capital Partners, in Atlanta.

Since Angel Oak Multi-Strategy Income made its debut in June 2011, it has returned 24.1%, compared with 6.1% for the Barclays Aggregate Bond Index. Last year, the fund returned 22.7%, crushing its rivals in the multisector bond category by an average of 11 percentage points and putting it in the top percentile.

This year, however, is off to a rockier start. The fund is down 0.1% amid the broad market selloff, but that's still nearly two percentage points better than the index. In the meantime, it's delivering a yield of 4.42%.

Friedlander credits the fund's outperformance largely to its heavy weighting in nonagency mortgages that originated in the early- to mid-2000s. Nonagencies include everything from so-called jumbo loans—which exceed the roughly $400,000 to $730,000 mortgage the government will back—to lower-quality mortgages and subprime loans.

Nearly 70% of Angel Oak's assets are invested in this "private label paper," far more than any other mutual fund. Friedlander avoids subprime loans, which helped keep his fund from losing money along with its peers as those securities took a big hit in June. Instead, he focuses on jumbo loans that were issued before the financial crisis. What makes these mortgages of pre-bubble vintage so attractive, says Friedlander, is the continuing disconnect between their credit ratings and their inherent value.

Credit-rating agencies "absolutely obliterated the sector" after the housing crisis, stripping these securities of their investment-grade status. This led to forced selling by banks and other institutions, which are restricted from holding non-investment-grade bonds. Now nonagencies are available at 88 cents on the dollar, and Friedlander has taken advantage of the discount.

That's not his only focus, though. Collateralized loan obligations—bank loans backed by tangible assets—account for 15% of the fund. And Friedlander generally keeps 20% of the fund in very liquid assets, including government-agency debt.

Friedlander's knowledge of the mortgage market comes in part from having a front-row seat to the mortgage meltdown. He managed $8 billion of mortgage-backed securities for Washington Mutual before leaving in March 2008, six months before the bank's failure, and after he had become concerned about its future.

During the crisis, Friedlander saw investors flee from any and all mortgage-backed securities, but suspected there was more to the story. In May 2008, he and WaMu colleague Sreeni Prabhu joined mortgage-industry veteran Michael Fierman to found Angel Oak Capital Partners. "We saw a generational opportunity," Friedlander says.

The team first launched one hedge fund, which gained 57.8% between its July 2008 launch and its closure five months ago.Its best-performing hedge fund has scored a gain of 176.6% since its inception in early 2009. Between its mutual fund and hedge funds, Angel Oak manages $3 billion in total assets.

TRUE TO HIS OPPORTUNISTIC approach, Friedlander snapped up assets during the market's recent soft period. The fund had been stockpiling cash, which Friedlander unleashed on purchases that now account for 25% of its assets. Much of that is in high-quality fixed-rate and hybrid mortgage bonds as well as floating-rate bonds composed of certain types of adjustable-rate mortgages. The fund now has less than 1% in cash.

Meanwhile, the housing market is looking better than it has in years. Home prices in April were up 12.1% compared with a year earlier, according to the S&P/Case-Shiller home-price index. The increase was the largest in seven years. And new homes sold at an annual pace of 476,000 in May, according to the U.S. Census Bureau—the best reading since July 2008. As the housing recovery continues, many related securities will appreciate. What's more, 70% of the mortgages the fund holds carry adjustable rates. That means the fund is positioned to serve as a hedge against inflation and rising interest rates, says Terrence Demorest, senior portfolio manager at Westmount Asset Management, a $1.6 billion investment advisor in Los Angeles. "We consider this a core position," says Demorest, who uses the fund for as much as 30% of his clients' fixed-income portfolios. "We have a lot of faith and conviction in what they're investing in."

Friedlander buys pools of mortgages rather than individual securities, but says he keeps a close eye on quality. He likes to see a large component of jumbo or "ultralux" loans behind the securities. These typically perform well in an improving economy, and rising home prices mean there's more collateral should a default occur. Friedlander prefers mortgages for owner-occupied properties, which have lower default rates than those for rentals or vacation homes. He looks for borrowers with substantial equity, and likes to see geographic diversification within a loan portfolio.

Friedlander has been looking at other kinds of structured credit, including commercial mortgage-backed securities and the student-loan market. Should events like sharply rising interest ratespush investors in those areas into panicked selling, says Friedlander, "this fund is ready to pounce on the opportunity."